State Franchise Authorities: Backdoor Merit Review

Certain State franchise authorities provide the sole regulatory buffer between unproven rookie franchisors and prospective franchisees. They are the only regulators that review or even receive a pre-sale copy of a franchisor’s franchise disclosure document (FDD), a uniform set of franchise offering disclosures that provide significant, but not complete, information about a prospective franchisee’s investment. (The federal franchise regulator, the Federal Trade Commission, does not review the FDD before it is used in a franchise offering).

There are, however, only a limited number of states that require an FDD to be filed with their franchise authorities and even fewer that conduct a thorough review. There are fewer still that have or wield any authority to impose any substantive conditions on the franchise offering. Nevertheless, these few states may temper the otherwise unbridled sales instincts of many emerging franchisors, even if they are not currently offering franchises in any of these states. Finally, a prospective franchisee in a non-registration state can borrow at least one page from the state franchise authorities’ playbook.

So, who are these states? What do they do? What don’t they do? And what preventative devices do they have in their toolbox?

“Registration” States

A common observation is that there are 14 “registration” states. That’s not entirely accurate, however, as not all “registration” states conduct any sort of FDD/franchise examination or review.

The 14 “registration” states are:

California

Hawaii

Illinois

Indiana

Maryland

Michigan

Minnesota

North Dakota

New York

Rhode Island

South Dakota

Virginia

Washington

Wisconsin

What “Registration” States Do for Prospective Franchisees

Among the states listed above, only 10 conduct any meaningful compliance review, and the thoroughness of the reviews varies considerably among these states. And Indiana, Michigan, South Dakota and Wisconsin are effectively notice states, with no review at all.

For the states that conduct a review, they typically look at the following issues:

Compliance with the applicable state franchise law

FDD disclosure compliance review

Financial statements

Prior convictions of any franchisor officer or director under the applicable state franchise law

What “Registration” States Do NOT Do for Prospective Franchisees

The most important thing that state franchise authorities do not do is pass on the wisdom of a particular franchise investment. In fact, many of the “registration” states require a specific warning that they do not do so and provide that any statement to the contrary is a violation of the state franchise law. So, state regulators may determine that an investment in a specific franchise is almost certain to be a poor, maybe even terrible, deal, yet, short of a finding of fraud, misrepresentation or other illegality, they can do very little. In this sense, even though some states are described as conducting a “merit” review, that review has nothing to do with the investment merits of the franchise offering.

Nevertheless, state franchise authorities have some important tools that can effectively impose a substantive “backdoor” merit review on an otherwise compliant but feeble franchise offering. (If a franchise offering is not compliant, states may suspend, prohibit or deny the sale of a franchise through a stop order, cease and desist order or other device).

Preventative Tools

First, and perhaps most important, state franchise examiners may exercise their “impoundment” authority and require a franchisor to escrow any franchise fees and other funds paid by a franchisee until the franchisor’s pre-opening obligations under the offering have been satisfied. These franchisor obligations may include such things as training, real estate, improvements, equipment and inventory.

Impoundment is generally required when the franchise authority determines that the franchisor fails to demonstrate “adequate financial arrangements” to fulfill its obligations. While some of the state authorities with whom I spoke in preparation for this article did not want to reveal their secret sauce for this determination, some state franchise laws and regulations spell out specifically what the state franchise authorities consider. For example, the Illinois franchise administrator (the Illinois Attorney General) will look at the following criteria in making its determination whether adequate financial resources are available for the franchisor to fulfill its pre-sale obligations:

Financial statements

The auditor’s opinion letter or review report

Notes to the financial statements

The current ratio

The quick ratio

The amount of working capital

The proportion of tangible and intangible assets

The amount and maturities of debts

The debt/equity ratio

The amount of equity

The earnings history

The proportion of receivables compared to other assets and

The quality of receivables

In addition to an escrow of franchise fees, impoundment may take the form of a surety bond, performance guarantee or deferral of franchise fees. Unsurprisingly, some franchisors are reluctant to agree to the last as that reverses the creditor/borrower roles (i.e., franchisees reasonably may think of the payment of their franchise fee as an extension of credit to the franchisor that isn’t satisfied until the franchisor’s obligations are met). Still, more franchisors tend to choose the deferral option as it avoids the fees and delays associated with the other alternatives.

Second, states may require specific risk factors that reflect their substantive views about the merits of the franchise investment. For example, states may require risk factors that warn the prospective franchisee that:

The franchisor’s operating history may be too limited to assist you in judging whether or not to make the investment

Your spouse’s personal assets will be at risk because he or she must sign a personal guarantee

Substantially all of the franchisor’s assets are intangible

You may only settle a dispute by arbitration and you may arbitrate or bring a lawsuit against the franchisor in a certain state and that arbitration or lawsuit will be governed by the laws of that state

A large number of units closing within a specified number of years

The franchisor controls the amount, size and location of customer accounts

The franchisor may take away territorial protection or exclusivity if the franchisee fails to achieve a certain sales volume or satisfy some other contingency.

Of course, the protections described above generally may not affect you as a prospective franchisee if you do not reside in or intend to establish your franchise unit in a “registration” state. I say generally because many growing, forward-looking and reputable franchisors will anticipate “registration” state-compliance requirements even if they are not currently offering a franchise investment in such states. That’s because few franchisors want to preemptively foreclose the huge market potential represented by the “registration” states. Moreover, if your franchise system has a large enough national or regional footprint, the odds are that they will be offering and selling franchises in at least one “registration” state and you will be the beneficiary of that state’s review, whether you reside in or set up shop in that state.

And even if the franchise you’re considering ignores the possibility of offering in a registration state, you can take a hammer from the state franchise authorities’ toolshed by, for example, having your accountant make a determination for you whether the franchisor has adequate financial resources to fulfill its obligations to you.

Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.

This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.